|Investing in Bonds|
Remember the story of the race between the tortoise and the hare? The hare ran all around diverting from the racecourse and stopping for distractions along the way. The tortoise, on the other hand, stayed the course albeit at a slower pace. Guess what, the hare was so distracted, the tortoise won the race.
The hare strategy of investing can be tempting – you obtain large profits quickly, and it feels rewarding. However, hare portfolios burn out quickly, while tortoise strategies steadily increase their returns, winning with a greater portfolio value in the end.
Investment benefits of bonds
Bonds can offer you financial security, or as much as you can expect in a constantly changing market. Most bonds provide a fixed income stream throughout their term with face amount due upon maturity or when called. Most investors have heard that diversification is the key to a profitable portfolio. If you have riskier investments already, bonds make a good safety net for your investment portfolio.
While few things are more certain than taxes, bonds are often free from some of the taxes. If you obtain a bond from a State or Municipal government, the interest will likely not be subject to Federal or State income tax. On the other hand, Federal bonds are only exempt from most State income tax requirements.
Treasury bonds are considered the safest, followed by municipal and then corporate bonds. Treasury bonds are backed by the US Federal government, and therefore, your risk of default on these bonds is minimally low. For other types of bonds, you must ensure that you are comfortable with the issuing organization. Most municipal bonds are backed by insurance companies, and this can help you gauge your risk-to-reward ratio. Corporate bonds are associated with a credit rating that determines its probability of fulfilling the obligation to you.
As long as a bond has a high credit rating, the risk of default is slim.
The risks involved with bonds
If you need your money before maturity, some bonds can be sold early. You will simply collect the interest you have earned up to that point. However, there is a risk that you will not receive your initial investment back if the market conditions have deteriorated since you purchased the bond.
In other cases, the issuing company can call a bond back early. If that happens, you will receive the face value of the bond, as well as the interest that you earned while you held the bond. However, companies and governments tend to call their bonds back when interest rates are low. This can make it difficult for you to reinvest your money at the same rate you previously received.
The best way to use bonds for your portfolio is to retain them until their maturity date or to only sell in a rising bond market. If you need your money back sooner, you may not be able to regain your initial investment if interest rates have risen. Remember that as interest rates rise, the market value of existing bonds drops and vice-versa.
Bonds are an ideal investment tool for the long term investor. Before buying a bond, think about when and for what you will need the money for in the future. If you are saving for retirement or your child’s college tuition, bonds are a safe bet – for shorter term goals, you might want to look towards other financial tools.